Forecasting%20Exchange%20Rates

1
Forecasting Exchange Rates

• Forecasting Techniques
• The Role of the Efficient Market (and Market
  Based Forecasting Models.
• Fundamental and Technical Analysis.

2
Initial Observation

• Since demise of the Bretton Woods fixed exchange
  rate regime in the early 1970s and the resulting
  move towards more flexible exchange rates, the
  need to forecast exchange rates has
• (1) become more important and
• (2) probably more difficult.

3
Pound and Yen During Bretton Woods

• Japanese Yen

• Pound Sterling

4
Pound and Yen Post Bretton Woods

• Pound Sterling

• Japanese Yen

5
Why Is There a Need to Forecast?

• Multinational Business Firms
• Hedging decisions (managing foreign exchange
  exposures)
• Financing decisions (where to raise long term
  capital)
• Capital budgeting decisions (FDI locations)
• Profit remittance decisions (when and where to
  move profits)
• Short term financing decisions (managing idle
  cash)
• Global Investors
• Constructing appropriate portfolios

6
Three FX Forecasting Approaches

• Efficient Market Approach
• This model assumes that todays spot exchange
  rate fully captures all relevant pricing
  information.
• Technical Approach
• These models assume that charts depicting
  historical movements in spot rates are useful in
  predicting future moves in spot rates.
• Fundamental Approach
• These models focus on macroeconomic variables and
  government policies that are likely to influence
  a currencys future spot rate. These models can
  be divided into two sub groups
• Non-parity models Look at demand and supply
  pressures.
• Asset Choice, Balance of Payments, etc.
• Parity models Estimate equilibrium prices
  through economic based formulas.
• These models were the subject of previous
  lectures.

7
Efficient Market Approach

• Efficient Market Model postulates that foreign
  exchange markets are efficient if
• All relevant pricing information is quickly
  incorporated into current spot exchange rates
  this information includes
• Current (i.e., new) financial, economic, and
  political information/data, and
• Historical financial, economic, and political
  information/data, and
• Expectations regarding these variables (i.e.,
  expectations for the future).
• Thus the spot rate includes what it knows and
  what it thinks it knows about the future.
• Based on this information, the foreign exchange
  market is making its best estimate (optimal
  forecast) as to the spot rate.

8
Efficient Markets and Forecasting

• If foreign exchange markets are efficient and
  current spot rates reflect, historical and
  current information along with expectations for
  the future, then changes in spot exchange rates
  will only occur when the market receives
  information it did not expect (a surprise).
• However, unexpected information is unpredictable
  and probably random.
• And when surprises do happen, the spot rate will
  adjust quickly.
• Issue for forecasting Since we cant anticipate
  unexpected information, how can we forecast spot
  exchange rates?

9
Efficient Market (EM) Forecasting

• Issue What can advocates of the efficient market
  use to forecast future spot rates?
• They use market based models
• Either the current spot rate or
• The current forward rate to forecast
• the future spot rate.
• Assumes that a market based forecast is as good
  as any since you cant anticipate unanticipated
  information.
• These models also assume unbiased predictor
  errors, or specifically
• Forecasting errors should net out to zero over
  time.

10
Empirical Tests of Market Based Models

• (1) Comparing market based models
• Question Do forward rate models and the spot
  rate models produce the same forecasting results?
• Agmon and Amihud (1981) found that one
  forecasting method was not better than the other.
• (2) Testing market based models for unbiased
  predictors of future spot rates.
• Done through studies which examine market based
  forecasts in relation to a Perfect Forecast
  Line.
• Test Are the forecasts consistently above or
  below the actual (realized) spot rates?
• Studies suggest that market based approaches over
  long periods of time produce cumulative errors
  approaching zero.

11
British Pound Forecasts Along a Perfect Forecast
Line
12
Market Based Models Over the Short Term

• Even if we assume that market based models
  produce unbiased results over the long term, that
  is not the same thing as saying that they may not
  produce large errors over the short term.
• Questions
• Are there short term errors?
• If so, how large?

13
Market Based Forecasting Errors

• Use the following formulas for American Terms
  Quotations
• Absolute forecast error
• (Forecast Rate Actual Rate) /Actual Rate
• British Pound Example
• Current 30 day forward 1.5800 (Forecast)
• Current Spot rate 1.6100 (Forecast)
• Actual spot in 30 days 1.5900 (Actual)
• Forward Market Based Model Error
• (1.5800 1.5900)/1.5900 -0.01/1.5900 -0.63
• The forecast (1.58) underestimated the actual
  (1.59) by 0.63
• Current Spot Market Based Model Error
• (1.6100 1.5900)/1.5900 0.02/1.5900 1.26
• The forecast (1.61) overestimated the actual
  (1.59) by 1.26

14
Current Spot Market Based Model Errors 30 Day
Forecast of the Pound
15
Current Spot Market Based Model Errors 30 Day
Forecast of the Pound
16
Market Based Forecasting Errors

• Use the following formulas for European Terms
  Quotations
• Absolute forecast error
• (Actual Rate Forecast Rate) /Actual Rate
• Yen Example
• Current 30 day forward 81.00 (Forecast)
• Current Spot rate 83.75 (Forecast)
• Actual spot in 30 days 82.00 (Actual)
• Forward Market Based Model Error
• (82.00 81.00)/82.00 1.00/82.00 1.22
• The forecast (81) overestimated the actual (82)
  by 1.22
• Current Spot Market Based Model Error
• (82.00 - 83.75)/82.00 -1.75/82.00 -2.13
• The forecast (83.75) underestimated the actual
  (82) by 2.13

17
Current Spot Market Based Model Errors 30 Day
Forecast of the Yen
18
Current Spot Market Based Model Errors 30 Day
Forecast of the Yen
19
Spot Market Based Forecast Summary

• Pound

• Yen

• Daily Data
• N 933
• Mean error 0.79
• Standard Deviation 4.53
• Range 20.30 to -12.00
• Monthly Data
• N 130
• Mean error -0.01
• Standard Deviation 2.36
• Range 9.04 to 6.02

• Daily Data
• N 933
• Mean error -1.14
• Standard Deviation 3.72
• Range 13.13 to -13.21
• Monthly Data
• N 130
• Mean error - 0.18
• Standard Deviation 2.33
• Range 5.46 to 6.22

20
Summary Efficient Markets (i.e., Market Based
Models)

• Advantages of market based models
• Easy to use data are readily observable.
• Costless to use data are free.
• Disadvantages of market based models
• Conceptual Models dont force us to think about
  forces which may account for future moves in
  exchange rates.
• Even if we assume these models provide long term
  unbiased predictors, there are times, especially
  over the short run, when they may produce large
  single period forecasting errors.
• Implications for Global Firms and Global
  Investors Use with caution, given the potential
  for large short term forecasting errors .

21
Technical Analysis

• The second approach used to forecast exchange
  rates is called technical analysis.
• Technical analysis uses historical foreign
  exchange price data to predict future prices.
• Specifically, this approach looks for the
  formation of specific patterns of spot rate
  prices, which may signal future moves in spot
  rates.
• Approach relies heavily on charts (and computers)
  and thus is sometimes called a chartist
  approach.

22
Assumptions and Use of Technical Analysis

• Question Why does technical analysis assume that
  past price patterns can be used to signal future
  moves in foreign exchange spot rates?
• Technical analysis argues that spot prices are
  not random and that patterns will develop.
• Furthermore, these patterns can be used to
  predict future moves in exchange rates (i.e.,
  they repeat).
• Technical analysis focuses on very short term
  forecasting (within a trading day out to a couple
  of weeks or months).
• Thus, this approach is not useful for global
  companies concerned with longer term currency
  moves (e.g., over a year, or longer).
• This approach is used by currency traders.

23
Technical Analysis Approaches

• Today, there are many technical approaches to
  chose from. Among these are
• Moving Average Cross Over Technique
• Bollinger Band Analysis Technique
• We will examine these two approaches in the
  slides which follow.
• For a more complete and current discussion of
  technical analysis and technical signals see
• http//www.fxstreet.com/technical/

24
Moving Average Cross Over Strategy

• The Moving Average Cross Over Strategy compares a
  currencys current spot rate to some longer term
  moving average of past spot rates.
• Strategy looks for crossovers of the two series
  and uses the following rules
• When current spot crosses its trend on way up,
  this signals future currency strength.
• Trading strategy Buy long.
• When current spot crosses its trend on way down,
  this signals future currency weakness.
• Trading strategy Sell short

25
Cross Over Example Euro Spot to 60-day Moving
Average
26
Bollinger Band Analysis

• Bollinger Band Analysis is a technique which
  examines a currencys spot price in relation to
  pre-determined upper and lower trading bands.
• This technique first calculates the currency's
  simple moving average of the currencys spot
  rates over some historical period (this is called
  the SMA).
• Then two bands are calculated about this moving
  average
• 1. An upper band of the historical spot rates
  (which is plus 2 standard deviations from the
  SMA)
• 2. A lower band of the historical spot rates
  (which is minus 2 standard deviations from the
  SMA)

27
Using the Bollinger Bands

• Technique assumes that the tendency of a currency
  is to trade within the upper and lower band.
• Movement outside of the band produces the
  following 2 signals
• (1) When spot prices move above the upper band
  (i.e., above plus 2 standard deviations), the
  signal is the currency is overbought.
• This is a technical signal of future weakness.
• Trading strategy Sell short
• (2 When spot prices move below the lower band
  (i.e. below minus 2 standard deviations) the
  signal is the currency is oversold.
• This is a signal of future strength in currency.
• Trading strategy Buy long.

28
British Pound Bollinger Bands Around 90-day
Moving Average, January 2007 Sept 2007
29
Sources for Technical Analysis Charts

• http//fx.sauder.ubc.ca/
• http//www.fxstreet.com/index.asp
• http//www.saxobank.com/?ID101
• Subscription required.

30
Appendix 1 More on the Efficient Market
Hypothesis

• The following slides discuss the three possible
  forms of FX market efficiency and their
  implications for forecasting. These slides also
  cover some of the studies of FX market efficiency
  as they apply to developed and developing
  countries.

31
Three Possible Forms of Foreign Exchange Market
Efficiency?

• There are three possible forms of Foreign
  Exchange market efficiency, they are
• Strong-Form Efficiency All information, public
  and private (including insider information) is
  reflected in current spot exchange rates.
• Semi-Strong Efficiency All publicly available
  information is reflected in current spot exchange
  rates.
• Weak-Form Efficiency All past price and past
  volume information is reflected in current spot
  exchange rates.
• It is named weak form because prices are the most
  publicly and easily accessible pieces of
  information.
• The information contained in the past sequence of
  prices of a spot exchange rate is fully reflected
  in the current spot exchange rate.

32
Degree of Market Efficiency and Forecasting
Exchange Rates

• The degree of efficiency of the foreign
  exchange markets also has implications for
  forecasting future spot rates.
• Weak Form Current spot rates reflect all past
  spot rates.
• The information contained in the past sequence of
  spot rates is fully reflected in the current spot
  rate.
• Technical analysis (using historical charts to
  forecast) is useless.
• Semi-strong Form Current spot exchange rates
  reflect all publicly available information (such
  as interest rates, balance of payments,
  inflation, etc.)
• Changes in the spot rate will only occur in
  response to unpredictable news in the future.
• Strong Form Current spot exchange rates reflect
  all publicly available information and all
  private information.
• Assumes even if you had insider information, you
  could not predict spot changes in the future.

33
Testing The Efficiency of FX Markets

• Tests of the foreign exchange markets in
  developed countries generally conclude that they
  are weak form and semi-strong-efficient.
• The market is assumed to be semi-strong, if
  prices adjust quickly to publicly available
  information (Eugene Fama, 1970). For an interview
  with Eugene Fama see
• http//www.dfaus.com/library/reprints/interview_fa
  ma_tanous/
• Studies of developed countries suggest that
  unanticipated news has been a major determinant
  of exchange rate moves.
• Frenkel, 1981 and Cosset, 1985

34
Testing The Efficiency of Markets

• Tests of foreign exchange markets in developing
  countries, however, provide mixed results, some
  supporting weak form, but not semi strong
  efficiency. These studies include
• Masih and Masih, 1996
• Sarwa, 1997
• Ayogu, 1997
• Los, 1999
• Wickremasinghe, 2004
• Thus, in developing countries these currencies
  may not react quickly to new information as it
  becomes available.